Since the populist Five Star Movement and the right-wing League captured a combined parliamentary majority in Italy’s March 4th election, Italian politics has been at an impasse, with the two parties struggling to form a government. But now, with President Sergio Mattarella having rejected a M5S/League proposal to appoint the staunchly Euroskeptic economist Paolo Savona as Minister of Economy and Finance, the situation has taken a dramatic turn.

Rather than explore more moderate alternatives, the coalition initially abandoned negotiations and called for a new election. An attempt to form an interim technocratic administration chosen by Mattarella was followed by a clash with the populists, which could have led to a constitutional crisis and spooked the markets. Now the situation seems to have changed again, and a coalition government is back on the table. But the situation remains highly fluid – and volatile.

This is the first time in Italy’s postwar history that a coalition of parties from the political extremes has attempted to form a government without any input from centrist forces. For their part, M5S and the League represent two different, but possibly overlapping, constituencies. Whereas M5S’s stronghold is in Italy’s poorer south, the League’s is in the country’s prosperous north, where a large small-business community harbors fears of immigration, globalization, and high taxes.

Neither party represents Italians who want change but still support Italy’s membership in the European Monetary Union (EMU). These voters’ voice has been relatively subdued, but now Mattarella is tenaciously channeling it.

Euro or not?

A new election could take place as soon as this fall, or early in 2019. Either way, it will now essentially be a referendum on the euro. The campaign will be bitter and divisive, and the outcome will not generate greater certainty about the future. Elections to the European Parliament will be held in May 2019, and the situation in Italy will no doubt mobilize nationalist and Euroskeptic parties hoping to change the European Union’s political equilibrium.

Given that Italy is a founding EU member state with a long pro-European tradition, it is worth asking how we arrived at this point, and how the EU should respond.

Italy’s economic problems are rooted in low productivity, unfavorable demographics, and weak governance in many parts of the country – all of which pre-date the introduction of the euro in 1999. While Italy’s mainstream political leaders hoped that eurozone membership would create the conditions for far-reaching economic reform, the euro has instead deprived Italy of the means to engage in competitive devaluation.

With the exception of Greece, Italy has fared worse than any other euro member state since the 2008 financial crisis. But there is no use playing the blame game. Responsibility lies partly with the EU and its pro-cyclical policy rules, but mainly with Italy’s past leaders, all of whom failed to address its structural problems.

The Italian story is different from the Irish, Spanish, and Portuguese boom-bust narrative of recent years. Italy experienced neither a credit-fueled boom during its first decade of euro membership, nor a traditional bust. The country’s problems are structural and will require a creative reform program that addresses the deep causes of its dismal economic performance over the past 20-plus years. Unfortunately, neither EU-recommended fiscal discipline nor populist-style fiscal profligacy will fix this fundamental problem.

Instead, Italy needs aggressive action to help the truly productive parts of the economy grow faster and exploit potential external demand. Rather than designing industrial policies to subsidize the losers, Italy should be providing opportunities for new market entrants, to reverse the high rate of emigration by skilled young people. Italy also needs more public investment in infrastructure and education, which will require addressing corruption, inefficient judicial processes, and ineffective local institutions – problems that have dogged Southern Italy, in particular.

Reforming the EU

Beyond this domestic agenda, Italy also needs to pursue reforms vis-à-vis the EU, starting with a relaxation of constraints on public spending for pro-growth investments and new partnerships. More investment will require additional fiscal space. But, more importantly, Italy and the EU both need new ideas, and more trust on each side.

Of course, whether the EU would even engage in such a discussion in the absence of credible Italian leadership remains an open question. EU rules cannot easily accommodate the problems of a country that is unable to consolidate its debt as a result of structurally weak growth – even if it has run large primary surpluses for years.

More broadly, whereas the discussion about reforming eurozone economic governance has long focused on enhancing risk-sharing mechanisms to strengthen resilience against economic shocks and financial crises, that emphasis is somewhat beside the point in Italy’s case, because it offers no cure for structural weakness. Addressing the latter will require deeper EU-level cooperation on a growth agenda, which presupposes a formal deal on the timing and schedule of fiscal consolidation.

The economic agenda proposed by Italy’s populist parties is fanciful and unconvincing. But that is no excuse for the EU to maintain the status quo. It is time for EU leaders to start thinking outside the box to formulate a growth strategy for the bloc’s fourth-largest member state. At this point, Italy looks more like Japan than Spain or Portugal, and policies need to reflect that fact.

Italy and the EU are at an inflection point. In the absence of concerted action, we may well be sleepwalking toward another euro crisis – one that would be much harder to overcome than the last, and which could threaten the current composition of the EU itself.

Republication forbidden. Copyright: Project Syndicate 2018 What Italy’s Crisis Means for Europe

In this fast-changing story Five Stars and the League agreed Thursday evening to form a government  and won presidential approval (see here)